Don’t Submit to Market Distortions
September 16, 2015
After years of steadily rising markets, distortions have become embedded in the landscape. We believe there are several large market imbalances that investors may be exposed to in passive portfolios today.
Market distortions develop for many reasons. Benchmarks can become heavily concentrated in a popular sector or region. Bubbles are inflated by pipe dreams. Valuations may reflect fleeting fads instead of the true economic worth of a company. But the good news is that by detecting imbalances in global equity markets today, investors can take steps to avoid them.
Safety Premium Persists
Safety commands a big premium today. Although nearly seven years have passed since the global financial crisis, bouts of turmoil still trigger defensive reactions from investors. As a result, there’s a 41-percentage-point spread between the relative price/book values of global low-beta stocks—which are generally perceived as safer—and their riskier high-beta peers (Display, left). That’s a wider spread of valuations versus the broad market than we’ve seen 90% of the time since 1972.
It’s even more pronounced in Europe. As the Greek crisis has compounded fears that the region is inherently riskier than others, the valuation gap between high- and low-beta stocks has widened to 137 percentage points (Display above, right)—the widest by far since 1986. In other words, investors are paying a huge premium to the market—and three times the price of the highest-beta cohort—for European stocks that are considered safer but might ultimately prove to be very risky if the safety trade reverses.
Asia also faces a quality bubble, which has been reinforced by recent volatility in China. The most profitable fifth of companies in Asia (excluding Japan) trade at a record 3.3 times higher than the least profitable fifth of companies—exceeding the premium during the global financial crisis. From a regional perspective, over the last few years, southeast Asian countries, which are generally considered safer, have performed much better than north Asian countries, which are considered riskier. We think investors in the region are paying too big a premium for earnings quality.
Inside the Emerging Markets Index
More broadly, emerging markets present particular challenges. For example, public equity markets include a high concentration of government-owned companies. In China, 61% of companies listed on the Shanghai Stock Exchange Composite Index are at least 20% owned by the government; in Russia, it’s 48% of the benchmark.
The problem is that government-owned companies are often poorly run. The state’s focus on creating jobs and supporting economic growth doesn’t always jibe with shareholder interests, as the Petrobras scandal in Brazil reminds us. Yet investors in an emerging-market index will be stuck with many government-held companies by default.
Commodities are another sensitive point. Many developing countries—including Brazil, Russia and South Africa—are big commodity exporters. In fact, 11 commodity-dependent countries account for about a third of the entire MSCI Emerging Markets Index. So if you invest in the index, you’ll be tied up with large weights in countries that are directly affected by what could be a prolonged commodities slump.
Bubble in Biotech?
Back in the US, the biotech industry looks bubbly. So what happens if an investor wants to get a piece of the exciting developments in biotech via an exchange-traded fund, which includes 147 companies? First, the investor is buying an index in which 57% of the companies are unprofitable. Second, the top five companies account for 39% of the index—but their earnings represent 84% of the total.
The biotech index is a tale of two types of companies: a profitable group of established businesses and a more speculative group of smaller companies. Both can be good investments, but owning all of them without scrutiny is risky. Instead, we would focus on select companies with clear advantages in promising areas, while paying close attention to valuation in this hot sector, to capture the tremendous growth potential of the biotech revolution.
Too Much of Financials
Finding undervalued stocks through an index or smart-beta approach presents different problems. Value stocks today are heavily concentrated in financials and energy. For example, in the Russell 1000 Value Index, financials accounted for 30% of the benchmark and energy accounted for 12%, as of July 31. If we isolate the cheapest quintile of US equities overall, 62% are financial stocks and 15% are in energy.
This means that investors deploying a passive or smart-beta approach to invest in value stocks may be heavily exposed to financial firms and energy groups, instead of holding a portfolio with diversified return drivers. Of course, there are opportunities in each of these sectors. But indiscriminate exposure to sectors facing significant challenges is fraught with risk, in our view.
Passive Isn’t Protection
The examples above illustrate that passive portfolios don’t necessarily provide protection. Investors in different types of index strategies may discover that they unwittingly have exposure to distortions that could exact a big cost in absolute terms when they unwind.
Passive portfolios are important. But we think they should be combined with high-conviction equity strategies that can identify imbalances and take selective positions in stocks that offer the strongest return potential to circumvent traps across stock markets.
This blog was originally published in InstitutionalInvestor.com.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams